Bias in financial decision-making

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Bias, banking and financial purchases

According to
behavioural economists, financial decisions are likely to be subject
to decision making bias. Given the nature of modern banking, made increasingly complex
following deregulation in the 1980s (Big Bang), and with the
subsequent development of new
financial
productsandsecuritisation, rational decision making was
made less likely. This, behavioural economists argue, is because
individuals default to System 2
decision making, and use compensating strategies in the face of
complexity such as rule of thumb
and other heuristic devises. Optimistic
framing by the
financial institutions prior to the
financial crisis may have created a
choice architecture which
increasingly diverged from rational decision making.

Taking the sub-prime
housing market
and related mortgage products as an example, a common rule of thumb which guided
decision making -
‘invest in property; you can’t go wrong’ – may well have been
the defaut position for many buyers. This position is likely to have
guided mortgage applicants (especially first-time buyers) in the face of
highly complex decisions, as well as enable them to make quick, often ill-thought through, decisions
as properties were 'flying off the shelf'.

It is
unlikely that many of these mortgage applicants read or understood the terms of
their contract. It also meant that, in the drive for sales, sellers of
mortgages used convenient rule of thumb guidelines to make quick
judgements about creditworthiness. Hence, both parties in the
increasingly ‘toxic’
sub-prime market made less than rational decisions - clearly it was not
in their self-interest, nor those of their families, to take on
unrepayable debts. Hence, we
can argue that transactions were based on a false reality with little
understating of how the market might move in the future.

Unlike tangible goods and face-to-face services, buyers and sellers
of financial products must rely much more on heuristics and trust, but
when a financial market 'gathers steam' the pressure is on to buy (or
sell), and the probability of a rational choice declines. The raises the
question of
regulation and intervention, including behavioural
nudging.